Monday, January 31, 2022 / by Jeff Lovato
While location is always a key consideration, there are numerous other factors that help determine if an investment is right for you. Here's a look at some of the most important things to consider if you plan to invest in the real estate market.
1. Property Location
The adage "location, location, location" is still king and continues to be the most important factor for profitability in real estate investing. Proximity to amenities, green space, scenic views, and the neighborhood's status factor prominently into residential property valuations. Closeness to markets, warehouses, transport hubs, freeways, and tax-exempt areas play an important role in commercial property valuations.
A key when considering property location is the mid-to-long-term view regarding how the area is expected to evolve over the investment period. For example, today’s peaceful open land at the back of a residential building could someday become a noisy manufacturing facility, diminishing its value. Thoroughly review the ownership and intended usage of the immediate areas where you plan to invest.
One way to collect information about what are the prospects of the vicinity of the property you are considering is to contact town hall or other public agencies in charge of zoning and urban planning. This will give you access to the long-term area planning and make a determination how favorable or unfavorable to your own plan for the property.
2. Valuation of the Property
Property valuation is important for financing during the purchase, listing price, investment analysis, insurance, and taxation—they all depend on real estate valuation.
Commonly used real estate valuation methods include:
- Sales comparison approach: recent comparable sales of properties with similar characteristics—most common and suitable for both new and old properties
- Cost approach: the cost of the land and construction, minus depreciation— suitable for new construction
- Income approach: based on expected cash inflows—suitable for rentals
3. Investment Purpose and Investment Horizon
Given the low liquidity and high-value investment in real estate, a lack of clarity on purpose may lead to unexpected results, including financial distress—especially if the investment is mortgaged.
Identify which of the following broad categories suits your purpose, and then plan accordingly:
- Buy and self-use. Here you will save on rent and have the benefit of self-utilization, while also getting value appreciation.
- Buy and lease. This offers regular income and long-term value appreciation. However, the temperament to be a landlord is needed to handle possible disputes and legal issues, manage tenants, repair work, etc.
- Buy and sell (short-term). This is generally for quick, small to medium profit—the typical property is under construction and sold at a profit on completion.
- Buy and sell (long-term). This is generally focused on large intrinsic value appreciation over a long period. This offers alternatives to compliment long-term goals, such as retirement.
4. Expected Cash Flows and Profit Opportunities
Cash flow refers to how much money is left after expenses. Positive cash flow is key to a good rate of return on an investment property.
Develop projections for the following modes of profit and expenses:
- Expected cash flow from rental income (inflation favors landlords for rental income)
- Expected increase in intrinsic value due to long-term price appreciation.
- Benefits of depreciation (and available tax benefits)
- Cost-benefit analysis of renovation before sale to get a better price
- Cost-benefit analysis of mortgaged loans vs. value appreciation
5. Be Careful with Leverage
Loans are convenient, but they may come at a big cost. You commit your future income to get utility today at the cost of interest spread across many years. Be sure you understand how to handle loans of this nature and avoid high levels of debt or what they call over-leverage. Even experts in real estate are challenged by over-leverage in times of adverse market conditions and the liquidity shortages with high debt obligations can break real estate projects.
Depending upon your current and expected future earnings, consider the following:
- Decide on the type of mortgage that best fits your situation—fixed-rate, adjustable-rate mortgage (ARM), interest-only, zero down payment, etc. Note that each type of mortgage has its own risk profile and you need to study each carefully. For instance, ARM includes mortgage rates that can change at any time driven by capital market forces and the borrower must accept any rate changes during the loan term.
- Be aware of the terms, conditions, and other charges levied by the mortgage lender.
- Shop around to find lower interest rates and better terms.
6. New Construction vs. Existing Property
New construction usually offers attractive pricing, the option to customize, and modern amenities. Risks include delays, increased costs, and the unknowns of a newly-developed neighborhood.
Existing properties offer convenience, faster access, established improvements (utilities, landscaping, etc.), and in many cases, lower costs.
Here are some key things to look for when deciding between a new construction or an existing property:
- Review past projects and research the construction company's reputation for new investments.
- Review property deeds, recent surveys, and appraisal reports for existing properties.
- Consider monthly maintenance costs, outstanding dues, and taxes. Costs such as these can severely impact your cash flow.
- When investing in leased property, find out if the property is rent-controlled, rent-stabilized, or free market. Is the lease about to expire? Are renewal options favorable to the tenant? Who owns the furnishings?
- Quality-check items (furniture, fixtures, and equipment) if these are to be included in the sale.
7. Indirect Investments in Real Estate
Managing physical properties over a long-term horizon is not for everyone. Alternatives exist that allow you to invest in the real estate sector indirectly.
Consider other ways to invest in real estate:
- Real estate investment trusts (REITs)
- Real estate company stocks
- Real estate sector-focused mutual funds and ETFs
- Mortgage bonds
- Mortgage-backed securities (MBS)
8. Your Credit Score
Your credit score affects your ability to qualify for a mortgage, and it impacts the terms your lender offers. If you have a higher credit score, you may get better terms—which can add up to substantial savings over time.
Scores greater than 800 are considered excellent and will help you qualify for the best mortgage. If necessary, work on improving your credit score:
- Pay bills on time—set up automatic payments or reminders
- Pay down debt
- Aim for no more than 30% credit utilization
- Don't close unused credit cards—as long as you're not paying annual fees
- Limit requests for new credit and "hard" inquiries
- Review your credit report and dispute inaccuracies
9. Overall Real Estate Market
As with other types of investments, it's good to buy low and sell high. Real estate markets fluctuate, and it pays to be aware of trends. It's also important to pay attention to mortgage rates so you can lower your financing costs, if possible.
Stay up-to-date with trends and statistics for:
- Home prices and home sales (overall and in your desired market)
- New construction
- Property inventory
- Mortgage rates
- Flipping activity
Real estate can help diversify your portfolio. In general, real estate has a low correlation with other major asset classes—so when stocks are down, real estate is often up. A real estate investment can also provide steady cash flow, substantial appreciation, tax advantages, and competitive risk-adjusted returns, making it a sound investment.
Of course, just like any investment, it's important to consider certain factors, like the ones listed here, before you invest in real estate—whether you opt for physical property, REITs, or something else.